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Normally greeted with cheers from shareholders, there is an insidious side to many share buybacks initiated by companies. With fewer shares outstanding, a company's earnings get spread across that lesser amount of shares, which will increase the company's earnings per share number. In sympathy with that, the higher earnings per share will tend to garner a rise in the price of the stock. If done at an apropos time it is a very good use of the company's capital. The way things should work and the way they do work are two different things, though. There are two major ways share repurchases are utilized that are less than beneficial for the shareholders, and these need to be watched out for.

Counteracting Executive Options Exercising

Dilutive on their own by increasing the amount of shares outstanding, this needs to be counteracted by the purchasing of shares on the open market, lest earnings per share now drop, which will in turn, likely lead to a lower share price. A Federal Reserve study displays how the companies which have the largest amount of executive compensation via stock options are less apt to distribute cash in the form of dividends. Here, here and here are some important facts to consider about this phenomenon:

  • From 1940 until 2011, over a 20 year moving average period, dividends account for roughly 60% of the total return of the S+P 500
  • From 1940 until 2011, the dividend payout ratio of the S&P 500 has been reduced nearly in half, from around 60% to 30%
  • Last decade was the third straight one in which the average dividend yield of the S&P 500 fell, from over 4% during the 70s to under 2% in the last decade

Returns are particularly affected in a decade where stock prices remain stagnant, like the one we recently experienced. Dividends account for an even bigger piece of the return. By shrinking yields in half and undertaking ineffectual endeavors instead, a shareholder's return suffers deeply.

Poor Timing For Initiation

Among the worst offenders displaying this type of behavior are Hewlett Packard (NYSE:HPQ) and Yahoo (NASDAQ:YHOO). Using HP's numbers as an example: during 2011, the company spent 7.6 billion dollars buying back stock at an average price of 38 dollars a share. The year before, another $11.3 billion was spent at an average price of 44 dollars a share. The shares currently trade at a hair over 20 bucks. In my last article, I also mentioned the example of The Washington Post Company (WPO) as guilty of improperly managing their share repurchase program.

They are not alone. Nearly 2 out of 3 companies from 2008 to 2011 had negative buyback effectiveness. This is based on the comparison of the buyback return on an investment to the total shareholder return, and displays whether or not it was done high or low relative to the trend of the share price. In fact, during the third quarter of 2007 alone, in which the S&P 500 was at record highs, 175 billon worth of shares were repurchased, which was much higher than all of 2009, where shares traded at a 40-50% discount.

Recently Phillip Morris International (NYSE:PM) announced a gargantuan buyback of $18 billion. Having this stock as a member of my own portfolio, I much rather would have liked to have seen the money used as a dividend, particularly since competitors such Altria Group (NYSE:MO) and Lorillard (NYSE:LO) have a dividend yield both of around 4.8% to Morris' 3.6%. Add to this, the stock has risen nearly 50% since the start of 2011.

If buybacks are going to be done, they need to be undertaken in the fashion Warren Buffett did with Berkshire Hathaway (NYSE:BRK.B). Strictly adhering to only repurchasing shares when they are conservatively calculated as selling at a material discount to the company's intrinsic business value, limits the risk that others constantly expose themselves to. As his 2011 shareholder letter explains, he only wound up purchasing $67 million worth before the price advanced beyond the cutoff point designated by him of 110% of book value. He realizes that continuing shareholders are hurt if shares are repurchased at elevated levels.

Paying out increasing dividends has a recognizably advantageous boost to stock returns. Studies show that companies raising their dividends increase both their stock returns and profitability for years after the raise. The track record of managers thinking they can put excess cash to better use than by raising dividends is not good. Shareholders need to display increased vigilance in both going through the proxy statements to vote against excessive executive compensation plans, which use options grants, and holding board members responsible for errant repurchase programs. As owners of the companies which you hold shares of, the managers are working for you, and your best interests are the ones they need to serve.

Source: The Use and Misuse Of Share Buybacks